1. Investment Objectives zPM must start with a clear objective! zFour-step process y1. Devise a policy statement y2. Study current financial/econ. Conditions y3. Construct portfolio y4. Monitor/update investor’s needs and market conditions zApplies to individual and institutional investors

2. Individual Investor Life Cycle zAccumulation phase zConsolidation phase zSpending phase zGifting phase

3. Individual Investor Life Cycle: Age matters! Net Worth Age Accumulation Phase Long-term: Retirement Children’s college Short-term: House Car Consolidation Phase Long-term: Retirement Short-term: Vacations Children’s College Spending Phase Gifting Phase Long-term: Estate Planning Short-term: Lifestyle Needs Gifts Figure 2.1

4. Life Cycle Investment Goals: Time Horizon and Cash needs Matter zNear-term, high-priority goals zLong-term, high-priority goals zLower-priority goals

5. Realistic Investor Goals zCapital preservation yminimize risk of real loss ystrongly risk-averse or funds needed soon zCapital appreciation ycapital gains to provide real growth over time for future need yaggressive strategy with accepted risk zCurrent income ygenerate spendable funds zTotal return (Maximize total, after-tax return!) ycapital gains and income reinvestment ymoderate risk exposure

6. Summary of Objectives as Input to Policy Statement zObjectives: yReturn xLT vs ST needs xTotal Return = Cap Gain + reinvestment income yRisk tolerance xCapital preservation xCapital appreciation xCurrent income z Constraints: yLiquidity needs yTime Horizon yTax Factors yLegal/Regulatory Factors yUnique needs and preferences

7. Investment Constraints zLiquidity needs ynear-term goals zTime horizon ylonger time horizon favors risk acceptability yshort time horizon favors less risky investments because losses are harder to overcome in a short time frame

8. Investment Constraints: Taxes Matter zTax concerns yinterest and dividends taxed at investor’s marginal tax rate ycapital gains may be unrealized ybasis and gain or loss realized yrevisions to capital gains tax rates ytradeoff with diversification needs for employer’s stock holdings yinterest on municipal bonds exempt from federal income tax and from state of issue yinterest on federal securities exempt from state income tax ycontributions to an IRA may qualify as deductible from taxable income ytax deferral considerations - compounding

9. Effect of Tax Deferral on Investor Wealth over Time $1,000 Investment Value Time $10,063 $5,365 Figure 2.5

10. The Effect of Taxes and Inflation on Investment Returns, 1969 - 1994 After Taxes and Inflation After Taxes Before Taxes Figure 2.6

11. Investment Constraints zLegal and Regulatory Factors yLimitations or penalties on withdrawals yFiduciary responsibilities - “prudent man” rule yInvestment laws prohibit insider trading zUnique Needs and Preferences yPersonal preferences - socially conscious investments yTime constraints or expertise for managing the portfolio may require professional management yLarge investment in employer may require consideration of diversification needs and realistic liquidity yInstitutional investors needs

12. The Importance of Asset Allocation zAn investment strategy is based on four decisions yWhat asset classes to consider for investment yWhat normal or policy weights to assign to each eligible class yThe allowable allocation ranges based on policy weights yWhat specific securities to purchase for the portfolio zMost (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments

13. The Importance of Asset Allocation: Suitability and Optimality zSuitability: The appropriateness of particular investments or portfolios of investments for specific investors zOptimality: developing a portfolio with the highest expected return for a given level of risk (also called efficiency)

14. Asset Allocation and Cultural Differences zSocial, political, and tax environments zU.S. institutional investors average 45% allocation in equities zIn the United Kingdom, equities make up 72% of assets zIn Germany, equities are 11% zIn Japan, equities are 24% of assets

15. Scenario 1 z70-year old widow provides her life savings of $300,000 to a financial planner. Portfolio earnings represent nearly all of her income. The planner places 50% of her funds in corporate bonds rated AA or higher and 50% in a variety of vehicles including penny stocks, options, and commodity futures. After two years, interest rates have fallen, but the total value of the portfolio is $240,000 due to losses and trading expenses of managing the speculative portion of the portfolio. zHas the planner acted ethically? zIs the portfolio suitable?

16. Scenario 2 zA 45-year old man with some investment experience opens an account with a discount broker. His wealth is sufficient to allow writing of naked options. He begins trading aggressively, primarily selling puts on stocks and stock indicies. In six months, he has accumulated losses in excess of $100,000. zIs the broker acting ethically? zIs the portfolio being maintained for him suitable?